Corporations raise capital in a number of different ways, issuing equity and equity linked products being some of the most common ones.
One popular instrument used to raise capital is known as the “convertible bond.” Much like a regular bond, a convertible bond entitles a holder to periodic coupon payments as well as the repayment of the principal amount at maturity. In addition, the holder has the right to convert his bond to a specified number of underlying shares, thus participating in the performance of the company's shares. The stock price at which it becomes economical for convertible bond holders to convert their bonds into the underlying shares is known as the conversion price. The recently published article in The Economist (Jul. 19, 2003, pp. 59-60), describes the convertible bond as “in effect, two financial securities in one: a bond, plus a call option on the shares.” While this description is not entirely accurate, it is sufficient for our purposes. The combination of the relative safety of regular bonds with the potential upside participation in the underlying shares renders convertible bonds an attractive instrument for investors.
A convertible bond issuer can significantly reduce the cost of capital compared to that of conventional debt by offering investors the upside participation in the underlying equity appreciation. The downside is that the potential conversion of the bond into shares may increase the number of outstanding shares of the company, thus reducing earnings per share. This phenomenon is known as “dilution.”
Several mechanisms have been pursued to partially reduce the risk of dilution inherent in convertible bonds and other similar instruments. The ideal way for a company to eliminate dilution would be to buy an offsetting call option (the right to purchase stock on a future date at a specified strike price) on the underlying shares struck at the conversion price. While this method would eliminate the dilution entirely, it would also negate all the benefits of convertible bond issuance, since the premium spent on a call option would cancel the benefits of cheaper funding rate achieved by an issuer through the issuance of convertible bond.
The next best solution for a convertible bond issuer is to buy (go long) a call option struck at the conversion price and sell (go short) a call option struck at a higher stock price. Such combination of long lower-strike call and short higher-strike call is commonly referred to as a callspread. For the purposes of this invention the expirations of the two calls comprising a callspread may or may not be the same. Additionally, the number of lower-strike calls in the callspread may or may not be the same as the number of higher strike calls. The price of a callspread is generally lower than that of a plain call option struck at the same lower strike.
As a result of such callspread purchase, an issuer effectively “shifts” the dilution problem to a higher stock level which is more tolerable for existing shareholders. FIG. 1a illustrates the use of a callspread as a tool to reduce the dilution when issuing an equity-linked note. Here the Issuer issues an Equity Linked Security to investors in which the Issuer provides the Investors with the ability to participate in the equity performance. In exchange for this the Investors will generally agree to receive lower coupon payments. The Issuer will then use part of the profits from the issuance to purchase a callspread option (as described above) from a Broker Dealer in order to increase its protection against potential dilution. When the shares underlying the Equity Linked Security appreciate in value, Investors will exercise their right to convert in which case the Issuer will exercise its callspread option thus receiving the shares from the Broker Dealer.
The specifics of callspread trading is well understood by people proficient in the field of financial derivatives and are described in detail in “Option Volatility & Pricing: Advanced Trading Strategies and Techniques” by Sheldon Natenberg, McGraw-Hill, 1994, pp. 203-211, incorporated herein by a reference.
A specific example of how a callspread purchase may be used by a convertible bond issuer to mitigate dilution is found in FIG. 1b. In this diagram, a convertible bond is issued by Issuer 1 to Investor 5. The notional of the bond is $1000. The assumed stock price on the day of the convertible bond issuance is $100. Without the loss of generality, we can assume that the convertible bond pays no coupons, i.e. investors are willing to forgo the interest payments entirely in exchange for the upside participation in the underlying stock (this is not unusual for convertible bond issuances). We further assume that the bond may be converted into 8 shares of common stock at any time prior to maturity. Assuming that both the interest rates and the issuer's credit status remain constant, it will become economical for the investor to convert his $1000 notional bond into 8 shares of common stock if the stock is above $1000÷8=$125. The issuer is therefore faced with potential equity dilution if the stock exceeds the conversion price of $125. Issuer 1 reduces his potential dilution by purchasing a callspread from Broker-Dealer 15. The callspread comprises a call option struck at the conversion price $125 bought by Issuer 1, and a call option, struck at a significantly higher price of $200 bought by Broker-Dealer 15. While in the general case, it is not necessary to match expirations of either call option with the maturity of the bond, for the purposes of this example, we assume the expiration of both options to coincide with the maturity of the convertible bond. For the purposes of this example, we assume that the number of lower strike calls is the same as the number of higher strike calls. Having entered into such arrangement with Broker Dealer 15, Issuer 1 has now effectively shifted the dilution risk from the original $125 to a much higher price of $200.
The fees associated with the callspread are determined using various per se well-known pricing models on options (see, e.g., Options, Futures, and Other Derivatives by John C. Hull, Prentice Hall, Third Edition, 1997, the contents of which are incorporated herein by reference). Various hedging techniques are thereafter employed by the callspread seller to reduce the risk associated with the transaction.
Similar investment arrangements have recently been implemented on a commercial basis as outlined below in a published excerpt:                “Computer Associates, Cypress Protect Shareholders From Dilution        2003-06-23 03:01 (New York)        June 23 (Bloomberg)—Computer Associates International Inc. and Cypress Semiconductor Corp. are among companies that have borrowed money with the expectation that their shares would rise, and they covered their bets in case they guessed right.                    These companies and others including Navistar International Corp. and Micron Technology Inc. have raised money by selling convertible bonds, which are repaid in stock instead of cash if their seller's shares rise to a set price.            Handing over a pile of shares has a drawback: dilution that cuts the value of stock investors hold already. To protect those shareholders, the companies are spending as much as 16 percent of their bond sale proceeds to buy call-spread options. These let companies purchase enough stock at a preset price to help counter the reduction in per-share profit investors would take otherwise.            “For companies who are bullish on their stock and want to minimize dilution, call-spread options are an attractive feature to augment a convertible deal,” said Steve Wachtel, technology analyst at Froley Revy Investment Co., a Los Angeles-based money manager that specializes in convertible debt.”                        
A substantially similar strategy can be utilized by a convertible bond investor. In this case, the investor may choose to buy a callspread from a Broker-Dealer to reduce the conversion price of a convertible bond and increase the probability of conversion into the underlying shares.
The investment vehicles described above have at least two significant drawbacks that may limit their appeal to a wider spectrum of potential users. First, the cost of the callspread option can be significantly high. And second, the benefit of the dilution protection may become irrelevant if the market price of the underlying stock decreases substantially, since the possibility of achieving the conversion price becomes very remote. Similarly, the opportunity for a convertible bond investor to benefit from the conversion rights associated with the convertible bond are far more attenuated if the market price of the underlying equity drops.